On October 26, the Washington Post released an insightful investigative report on disclosures of exempt organizations with a "significant diversion" of their assets. The report highlights the range of problems, including embezzlement, theft, fraud, and misuse, that can afflict exempt organizations of all types and sizes. Accompanying the report, the Post also published a new searchable online database, created in cooperation with GuideStar, which lists every exempt organization since 2008 that has reported a significant diversion of assets on its Form 990. We applaud the Post for shining a spotlight on this issue, and for developing the database and making it available to the entire nonprofit sector. The report itself serves as a reminder—just in time for Form 990 filing season—that exempt organizations must be vigilant in safeguarding their assets.

Form 990 Disclosure Requirements

Since the last major revision of the form in 2008, the Form 990 has explicitly asked organizations to report if they became aware, during the tax year, of any "significant diversion" of assets. For 990 reporting purposes, a "diversion" occurs when there is any unauthorized use of the organization's assets for noncharitable purposes. And a diversion is "significant" if the gross value of the diversion exceeds the lesser of (i) 5% of the organization's gross receipts for its tax year, (ii) 5% of the organization's total assets as of the end of its tax year, or (iii) $250,000. Importantly, organizations should be aware that the dollar thresholds are cumulative; thus, several small, unrelated diversions could trigger the reporting requirement. If a significant diversion has come to light during the reporting year, even if the diversion occurred in any earlier year, the filing organization must check "yes" on line 5 of Part VI and "explain the nature of the diversion, amounts or property involved, corrective actions taken to address the matter, and pertinent circumstances on Schedule O … although the person or persons who diverted the assets should not be identified by name." The same diversion of assets may need to be reported in multiple places on Form 990. For example, if the diversion gives rise to an excess benefit transaction under Internal Revenue Code section 4958, the organization should disclose the discovery in Part IV, line 25, and the relevant facts should be reported on Schedule L (Interested Party Transactions). In addition to federal tax reporting, there may be analogous state tax reporting obligations to consider. And of course, organizations should carefully discuss the relevant facts with their independent auditors in connection with the preparation of annual financial statements.

"Remember that some of these filings and documents will find their way into the public domain—if not because of a statutory mandate, as with the Form 990—perhaps because the organization chooses to voluntarily share the information with donors and regulators, or because a disgruntled employee leaks the story. This reality makes it all the more important to take a thorough and strategic approach to both the investigation and the disclosure of any diversions. The public—both donors and regulators—will expect the organization's stewards to take timely and decisive action to remedy the situation."

Tip of the Iceberg?

Although tax and financial disclosure deadlines are often the initial triggers for important conversations with internal stakeholders (e.g., relevant officers, members of the Board, counsel, financial advisors), for many organizations this is just the first step in the process of detecting and curing any failures in internal controls. Even in the most straightforward cases, nonprofit managers would be wise to seize the moment to review the organization's internal policies and procedures to prevent future lapses. Because the very fact of a significant diversion calls into question the effectiveness of an entity's internal controls, organizations may wish to consider engaging independent experts to assist in conducting an internal investigation to determine the full scope of the diversion of assets, whether the diversions were the result of ineffective procedures, lax oversight, or both, and to make recommendations regarding appropriate remedies. Corrective actions might include termination of employment, cancellation of grant agreements or contracts with third parties, and changes in internal control systems and procedures. In some cases, the organization may wish (or be required) to disclose the matter to the relevant authorities for possible criminal prosecution.

Mark Matthews, a senior Member in Caplin & Drysdale'sTax Controversies practice and former IRS Deputy Commissioner in charge of the agency's four civil operating divisions, agrees that nonprofit organizations and their managers will be judged by how well they handle the situation and what they do with the information once they discover a diversion of charitable assets.

For more than 45 years, Caplin & Drysdale has been a leading provider of a full range of tax and related legal services to companies, organizations, and individuals throughout the United States and around the world. With offices in New York City and Washington, D.C., the firm also provides counseling on matters relating to tax controversies, bankruptcy, creditors' rights, exempt organizations, employee benefits, private client services, corporate law, white collar defense, complex litigation, and political activity.

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Disclaimer
This communication does not provide legal advice, nor does it create an attorney-client relationship with you or any other reader. If you require legal guidance in any specific situation, you should engage a qualified lawyer for that purpose. Prior results do not guarantee a similar outcome.

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It is possible that under the laws, rules, or regulations of certain jurisdictions, this may be construed as an advertisement or solicitation.